Crikey Clarifier: what would happen if the US defaults?

US Republicans have edged a little closer to a deal with Barack Obama on the government shutdown and raising the debt ceiling. But what if that can’t meet the deadline? Crikey looks at the consequences.

Last week, the United States Treasury released a report on the global consequences of a default. It makes for stark reading:

“In the event that a debt limit impasse were to lead to a default, it could have a catastrophic effect on not just financial markets but also on job creation, consumer spending and economic growth with many private sector analysts believing that it would lead to events of the magnitude of late 2008 or worse, and the result then was a recession more severe than any seen since the Great Depression.

“Considering the experience of countries around the world that have defaulted on their debt, not only might the economic consequences of default be profound, those consequences, including high interest rates, reduced investment, higher debt payments, and slow economic growth, could last for more than a generation.”

Overnight in America, Republicans proposed a deal where they would raise the debt ceiling for six weeks in order to negotiate a solution. However, President Obama rejected the deal as it would not re-open the government in the meantime. Australian businesses with operations in America told Crikey the chatter is that a deal will be reached by Monday.

America has never defaulted on its debt. It has never had need to. It still has no need to. But a political impasse means its $16.7 trillion debt ceiling is being used as a bargaining chip by Republicans to ensure the scrapping or delay of legislation passed by Democrats in the previous political cycle.

The American government is already shut down and has been for nine days, as Congress Republicans refuse to put a budget to a vote unless it cuts funding to President Obama’s healthcare reforms. But a bigger day is coming. On October 17, America is scheduled to breach its debt ceiling. And while few think it will come to that, here’s what would happen if it did …

On October 17 …

America will breach its debt ceiling on October 17, given current spending and taxation flows. That means the Treasury Department would not be allowed to borrow more money to pay its expenses.

Treasury Secretary Jacob Lew has said there will be $30 billion on hand to use on this date to pay the bills, an amount he said was “not responsible”. All government spending goes through Treasury, so that $30 billion will be quickly eroded by scheduled payments to government programs like social security.

On October 30 …

This is when Treasury says it will run out of money. This is just for domestic spending. A lot of government departments are already shut down, but this means essential services currently exempted — schools and defence contractors, for example — would begin to be affected.

On October 31 …

This is the point of no return. America owes a $6 billion interest payment on this day, and the money to pay it would not be available.

“This is when the proverbial would hit the fan,” AMP Capital’s chief economist Shane Oliver told Crikey. “America’s never defaulted in that sense before. Greece came close a few months back, but that didn’t matter. Greece isn’t core to the global financial system.”

If America were to fail to make that repayment, credit rating agencies would have to class it as being in “selective default”. And this would ensure the knock-on effects continue. Global pension funds, central banks, you name it, all invest in American government debt. Many have mandates saying they can only invest in BBB-rated investments and above.

“If America downgrades, many will be forced to sell their US bonds, and that’ll put upwards pressure on bond yields,” Oliver said. “Interest rates would quickly rise.”

There would be other effects too, some caused by the higher interest rates and some just by the whole situation. Confidence in America would decline, sending the dollar plunging. Borrowing costs for businesses would escalate rapidly, as many global interest rates are tied to the price of US government debt.

We saw this happen in Europe, Oliver says. “When those countries had debt downgrades, their bond yields went up even before the downgrades occurred. The effect of this was that companies in those countries faced higher borrowing costs,” he said.

Westpac economists Sean Callow and Richard Franulovich wrote yesterday that this’ll keep the American dollar low, which could have positive effects for the Australian dollar. However, they’re not expecting a dramatic change from where it is now.

On November 15 …

Two weeks later, another, far larger interest repayment is due. If a deal still hasn’t been reached, America would default on $30 billion in scheduled repayments, throwing markets further into chaos.

And after that …

It’s not really clear what would happen beyond that point. While America could miss a few more payments, it’s unlikely to keep doing so indefinitely, Oliver says.

That’s because America still has trillions of dollars in tax coming in. It will breach its debt ceiling because its budget is not currently balanced. But if it were to pass a balanced budget — one that contains enough money to pay its liabilities while meeting its interest repayments by doing a mix of raising taxes or cutting government services — it could continue to make repayments. However, this would likely choke off the global recovery, and the upheaval alone would likely be catastrophic for global economic growth.

There’ll be long-term consequences for America as well. The country currently enjoys enormous economic advantages by virtue of being the globe’s economic powerhouse, as well as its reputation for having never defaulted on its debt. America can borrow more cheaply, it has the world’s most important currency, it’s where successful companies the world-over flock to list. These and other advantages enjoyed by the American economy would be put at risk if the nation defaulted on some of its repayments.

“We’ve seen what happened to Argentina and Russia when they defaulted,” Oliver said. “It took them a long time to return to where they were. That stigma sticks for a while.

“America lost a lot of face through the global financial crisis. It was seen as having a strong, robust, innovative economy, and then the GFC tore holes through that concept. The world is increasingly starting to look towards China, and that comes as a difficult time for America. Another failure here could further accentuate perceptions of its economic decline.”

But back to reality …

Ultimately, however, few expect these catastrophic events to come to pass. “I think this is extremely unlikely,” Oliver said.

“If this does happen, it’ll be because of a miscalculation. At the moment, the main risk is that both sides assume the other will blink. Republicans think even if Obama says he won’t negotiate, he will, and Obama assumes the Republicans will cave in. If those assumptions are both wrong, we’ll have a lot to worry about.”

“Another failure here could further accentuate perceptions of its economic decline.

But back to reality …”

What do you mean “back” to reality? Are we talking about the same things here? The Government of the United States of America, right now, has shut-down.

Let me say that again: The Government of the United States of American, has shut-down.

Imagine if the board McDonalds shut-down the whole company because half the board couldn’t agree with the other half over what toy should be in the Happy Meals? Imagine if Coca-Cola shut-down because they couldn’t agree on what their next product launch should be.

Companies don’t do it, because it’s stupid. The American Government right now, is being profoundly stupid.

What, you reckon they’re going to suddenly stop being stupid?

Oh yeah, not to mention that this is THE SECOND TIME this has happened. And that’s even after the scare they all had the first time they almost defaulted.

It is clear there are elements within the US Government who have no qualms about pushing this to the brink - and over.

Miriam you needed to be more specific and it would have been useful if you had looked at implications to both the world and economy and Australia in particular. Paul Kurgman is trying to look at the implications within the US but having experienced first hand the default in Argentina in 2000 was an eye opener as to the knock on effects on society generally.

“Westpac economists Sean Callow and Richard Franulovich wrote yesterday that this’ll keep the American dollar low, which could have positive effects for the Australian dollar. “

What is the definition of “positive effects” for the Australian dollar?

I would have thought this would have the potential to make the Australian dollar rise dramatically against the US dollar, but if we are a country that is looking at exports as being important to our economy than the effects aren’t really positive, while if we believe that cheap imports are a bonanza for Australians, the effects *may* be positive, depending on whether the default causes rapid inflation, as those manufacturers or retailers who trade in US dollars have to lift their prices as the value of the US dollar falls.

@tonyfunnywalker: You might be interested to know that I did ask about the precedents. One of the distinctions Oliver made when I spoke to him was that unlike Argentina, America has enough money to easily pay its debts and is not currently in economic crisis. This suggests the situation would likely be more contained than what happened in Argentina.

@Kevin_T: I used ‘positive effects for the dollar’ to mean ‘it would appreciate in value’. Which exporters wouldn’t consider positive, but is positive in a strictly numerical sense. But it is sloppy - I’ll be more specific next time.

@gavinmoodie - nice to see someone in Australia notice - as a South American (way south, southern hemisphere south) it was once annoying (people thought south america was texas or florida), but now eye just rollingly amusing.

I find it sad that noone can see the upsides to US govt shutdown and even default. Lets start with remembering that the ‘recovery’ in US is a fiction cobbled together out of unprecedented money printing, crashing wages & conditions, & trashing of land and water resources by fracking for scraps of oil & gas. This BAU is not worth saving, & if crashing the whole corrupt & violent economic ponzi scheme is the only way to stop it, so be it.

John64 mcdonalds is not a democracy its a profit driven corporation where the board generally think alike.
Sure the usa is a pretty poor democracy basically representing corporate interests but its but your analogy us poor